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Monday, August 25, 2014

Conventional economic analysis assumes the behaviour of businesses is
always rational but, in reality, the booms and busts that cause the ups
and downs of the business cycle are driven by emotion more than rational
calculation: unwarranted optimism, greed, impatience, short-sightedness
and herd behaviour. Consider our resources boom.

The ideology of
economic rationalism says private enterprise can do no wrong;
ill-advised behaviour by business arises only through its rational
response to distorted incentives created by the misguided interventions
of governments.

This confers on the demands made by business a
sanctity the captains of industry are quick to exploit. But their
demands often aren't in the community's wider interest.

Now we're
emerging from the decade-long resources boom it's easier to view the
process with greater insight and make a more sober assessment of its
costs and benefits.

What happened was a huge jump in the world
prices of coal and iron ore as China's period of rapid economic
development of heavy industry and infrastructure caused global demand to
outstrip global supply.

Like miners in other countries, our largely foreign-owned miners lapped up the huge increase in prices and profits.

But
it didn't take long for greed ("the profit motive", if you prefer) and
the irrational optimism that drives the world's entrepreneurs to take
over, with companies seeking to exploit the high prices to the full by
expanding their production capacity as much as possible as fast as
possible.

What then kicked off was a multibillion-dollar race -
between rival companies in a country, but also with the many companies
in other countries, all expanding their capacity as fast as they could.

It
takes a long time to build new mines and bring them into production. So
the chances of your mine being completed in time to enjoy the
super-high prices aren't great - the more so because it's essentially a
self-defeating process: the more companies join the race and the harder
they try to be among the first to complete, the sooner supply catches up
with demand and prices start falling.

If mining companies were
more rational, fewer would join the race. But companies are just as
subject to herd behaviour as investors in a booming sharemarket. A
mining chief who didn't join the comp would be subject to heavy
criticism.

This is where the irrational optimism comes in. Each
individual entrepreneur is in no doubt he'll be among the race's
winners. We're gonna make a motza.

But while the miners are busy
gearing up, their foreign customers are just as likely to be coming
towards the end of their own boom in investment and construction. The
inevitable result is that the global mining industry moves from a
starting point of undercapacity to an end point of overcapacity.

This
is the eternal story of mining. Only in passing is it ever in
equilibrium; it's almost always in either under or oversupply - probably
spending a lot more time over than under, the less profitable of the
two conditions.

Now, this cycle isn't news to conventional
economics, with its familiar "cobweb theorem" and "hog cycle" seeking to
explain the phenomenon. But these models put too much of the blame on
the unavoidable delays in increasing production, and too little on
animal spirits.

And they don't prepare us for all the waste and
inefficiency involved in a resources boom. In the miners' race to be
first in and best dressed they compete furiously for resources, bidding
up hugely the prices of labour, equipment and materials, and ending up
with mines that cost them far too much to build.

They also develop
lower-grade mineral deposits, the exploitation of which becomes
uneconomic as soon as the world price drops back from its record
heights.

In the aftermath of the boom, many acquisitions are
written off, the chief executives who presided over these excesses get
the chop and are replaced by bosses whose main skill is cost-cutting.
They make speeches about how excessive Australian wages are.

Anyone
who has followed the fortunes of our big three - BHP Billiton, Rio
Tinto and Glencore Xstrata - will know just what I'm talking about.

In
their race-driven frenzy to start new projects, the miners always
portray themselves as impatient for God's will to prevail, with any
politicians or community members who have doubts about allowing them to
rip up the environment denounced as agents of the anti-progress devil.

In
the aftermath of such booms we realise we should have refused to be
rushed. Why does no economist ever warn us to be less short-sighted?
Their faulty model.